As part of the 2017 Tax Cuts and Jobs Act, opportunity zones are the first new community development program using tax incentives since the New Markets Tax Credit Program in 2001. If investors deploy capital gains in economically disadvantaged areas, they can defer taxes or even reduce tax liability on realized gains.
Governors determined areas that receive the designation and can select up to 25% of their state’s census tracts for the program.
Investments are made through a special purpose vehicle called an “opportunity fund.” These funds must certify twice each year that 90% of their assets are held in an opportunity zone. Capital gains must be rolled into an opportunity fund within 180 days of the realized gain to maintain compliance.
There are two parts to the incentives. First, capital gains used to fund investment in opportunity zones are eligible for tax deferral until 2026. Depending on length of time invested, a reduction in taxes on original gains is also possible. Second, if the investment is held for at least 10 years, gains generated from the OZ are tax-free.
Suppose you bought stock for $1 million, later sold it for $11 million and rolled the entire $10 million gain into an OZ investment.
- Taxes on the $10 million capital gain can be deferred until 2026.
- If invested for at least five years at the end of 2026, capital gains tax liability is for only $9 million (10% step up in basis).
- If invested for seven years at the end of 2026, capital gains tax liability is for only $8.5 million (additional 5% step up or 15% total).
- If OZ investment is sold for $20 million, generating another $10 million gain, the new gain would be tax-free if sold after a hold period of at least 10 years.
Because the OZ program is in its infancy, its impact is not yet clear. Real estate brokers nationwide report high levels of interest and capital being raised, but few transactions have closed. There are some notable increases in land transactions within opportunity zones. CBRE also is tracking dozens of prominent funds that, in aggregate, have a fundraising target of more than $12 billion for opportunity zone investment.
As is the case with a 1031 exchange, some buyers may be motivated to pay a higher price due to tax incentives. Early reports indicate some OZ properties have garnered a pricing premium of 5% to 10%. Any premium will depend on location and the specifics of each transaction.
Some OZs will be better suited for one property type or another, but in theory all property types can benefit from the program. As with any real estate investment, property-type selection is location dependent.
Although exact timing is uncertain, rules should be finalized during the first six months of 2019 and all indications are that they will be conducive to investment.
Opportunity zones enjoy broad bipartisan support. The OZ designation is set to expire in 2028, although tax benefits will remain until 2047.
Tax benefits are for capital gains investment only. It is possible to bring in capital from other sources, but it will be separated for accounting purposes and not eligible for tax benefits.
If an investor acquired the land from 2018 onward and a new structure is built, this should satisfy program requirements for tax benefits. For this reason, so-called “shovel ready” projects have seen an uptick in transaction volume.
Tax deferrals can be perpetuated indefinitely through 1031 exchanges, but in the case of opportunity zones, taxes on capital gains are deferred until 2026. Opportunity Zones also provide a different level of flexibility for investors. For example, you do not have to roll 100% of the proceeds of a sale into an opportunity zone investment. Investors may opt to deploy varying amounts of a capital gain into a new opportunity zone investment (though tax benefits of the program only apply to the portion of gain reinvested).
Opportunity zone designations are set to expire at the end of 2028, meaning investments must be made by that time. Capital gains generated though the end of 2028 are eligible for investment; however, that does not mean an investor needs to dissolve the investment at that time. Property can be held until 2047 and still enjoy tax benefits. In the nearer term, deferred taxes on invested capital gains are due by 2026. Because reductions in tax liability depend on time invested, investors must make investments before the end of 2019 to qualify for the highest level of benefits from the program.
Primary issues that must be addressed include rules governing funds with multiple assets in opportunity zones, the ability of existing property owners to participate in the program, clarification regarding compliance with program rules and guidance on compliance for funds buying and selling assets.